Incoming chief executives such as John Thain at Merrill Lynch or the new head of Citigroup will not have to face the ordeal of their predecessors in having to explain why they have lost so much money, but they face immediate significant challenges.

Nader Farahati, a director at consultancy Oliver Wyman, said: “Three pressing issues for investment banks are how to reward their best people, which growth bets are they going to take, and how they can control non-compensation costs, which have rocketed.”

Financial News has come up with a checklist of each issue as banks seek to negotiate the final weeks of their toughest year since 2001.

1) Compensation

Banks are facing one of the most bruising compensation rounds since the bull market started in 2002. Massive writedowns in fixed income and leveraged loan businesses have put staff bonuses under threat. But with some equity capital markets and mergers and acquisitions departments producing record revenues, banks must strike the right balance to keep top performers.

They are expected to weed out poor performers and several have removed heads of credit and fixed income divisions. Some, such as Citigroup, Merrill Lynch and UBS, have removed their chief executives.

These steps should be welcomed. Farahati said: “The removal of departmental heads is positive because it shows people are accountable and it creates opportunities for fresh talent to come through. In some cases, banks can reward their top performers with promotions if they cannot pay what they would like in bonuses. Reshuffles are positive because group-think can set in during a downturn.”

Job losses are not expected to be numerous. Farahati said: “The credit market was concentrated in the hands of six or seven leading banks and did not involve a large amount of people.”

He predicted significant jobs growth in Asia and new business areas would balance out cuts, reducing the total number of investment banking jobs globally between 2,000 and 5,000.

Investment banks are taking two approaches to remuneration this year. First, they are paying more bonuses in stock. Banks’ share prices have taken a battering in the second half, so they argue there is considerable upside to come.

A report last week by executive search firm Armstrong International said leading investment bankers on Wall Street and the City of London will receive up to 70% of their year-end bonuses in shares rather than cash.

Matthew Osborne, a partner at Armstrong, said: “By paying employees in shares and options, which vest over a certain period, the bank’s cost-to-income ratio is unaffected and, as a result, defers the pain of the bonus pool.” Typically, bankers receive about 30% of their compensation in shares and 70% in cash but this year that ratio could reverse.

Second, banks are reallocating bonus pools from divisions that have performed well to subsidise others. Farahati said: “Staff may not like it but management has to reallocate bonus pools across geographies or product lines. The exception is Asia, where bonuses will not be reallocated.” Banks deny reallocating bonus pools but the technique is accepted internally.

This year, mergers and acquisitions and equity capital markets bankers will be hit as their bonus pool is raided to help other divisions but, as one banker said: “Fixed income departments bailed out the M&A guys in 2002 and 2003, so they will return the favour.”

The good news for departments such as real estate and commodities that have enjoyed record years is that they do not have big bonus pools, so staff will not be disappointed. At the bottom end, banks will not pay bonuses to poor performers.

2) Making the right bets

Credit markets have been driving the growth of investment banking profits for the past five years, so the liquidity crunch leaves banks with the challenge of how to meet revenue growth expectations next year.

Farahati said: “We expect a full recovery in the credit markets but not until after 2008. We expect more writedowns but the fundamentals of risk transfer from the banking system to the capital markets remain in place.”

Despite the credit crunch, banks and their shareholders expect more growth next year and this means assuming more risk, although this is likely to be business or geographic risk rather than trading risk. Big growth areas are emerging markets, non-debt related structured products and commodities.

Emerging markets and commodities were at the top of the agenda last week when chief executives of Wall Street firms spoke at Merrill Lynch’s financial services conference.

Investment banks have been building in Russia, Turkey and the Middle East, which they hope will be significant providers of investment ranking revenue in 2008. Banks are fighting to win mandates from national governments, particularly in the Middle East, where sovereign funds are bidding for assets.

Banks have been building their commodities businesses in the past five years and many divisions have returned record performance this year. Progress has been made by Barclays Capital, Credit Suisse and Merrill Lynch as they seek to catch up with market leaders such as Morgan Stanley and Goldman Sachs.

Last week, Lloyd Blankfein, chairman and chief executive of Goldman Sachs, which is regarded as the number one commodities trading house, said commodities had produced a fifth of its fixed income, currencies and commodities revenues in the past five years.

Credit Suisse and Merrill Lynch are boosting their business through acquisition, which gives them expertise that would otherwise take years to acquire.

Last year, Credit Suisse signed a joint venture with Glencore, the world’s largest physical trader of base metals, while Merrill Lynch pulled off a coup in 2004 with its acquisition of the energy trading business of Entegy-Koch, part of US utilities firm Entegy. Its commodities trading team has since grown from 35 to 120 covering oil, emissions, coal and exotics.

Traders specialising in commodities are being promoted to reflect the importance of the speciality to investment banks. When Osman Semerci left Merrill Lynch last month as head of its fixed income, commodities and currencies division, which booked losses of $7.9bn (€5.6bn), the bank promoted David Sobotka, a vice-president and former head of its the global commodities group, to replace him.

Around the same time Credit Suisse promoted Adam Knight and Beau Taylor as co-heads of its global commodities business. Knight joined from Goldman this year and he and Taylor have been appointed to Credit Suisse’s fixed income and derivatives operating committee.

Samuel Molinaro, chief operating officer and chief financial officer at Bear Stearns, told Merrill’s conference he expects the bank’s new commodities’ division to be profitable next year. Bear Stearns this year bought Williams Power, the US energy trading business.

Barclays Capital is aiming to be number one in commodities and has been building its business since 1999. This year it signed a commodities joint venture with China Development Bank and has redeployed staff from London.

3) Controlling costs

Aside from spiralling compensation, banks have seen their infrastructure costs rocket in five years. These include IT and risk management, which require constant investment and upgrading.

Farahati added: “A fall in revenues exposes how much banks’ platform costs have increased.” Banks are involved in a number of in-house projects to tackle this issue.

Smaller banks are considering giving more budgetary power to individual business units in order to impose cost controls more locally. Farahati said: “Meanwhile, bigger banks are looking to take ‘offshoring’ to the limit by exporting costs to external providers. This could involve outsourcing functions such as human resources.”